Triple Leveraged ETFs Aren't What They Seem

When investment advisors and investors first hear about ETFs that use leverage to enhance the return of an index’s return in one direction or another, their reaction is probably like that of an old Saturday Night Live character played by the late, great Phil Hartman. 

“Unfrozen Caveman Lawyer” was a trial attorney who would try to get the sympathy of the jury by saying, “Ladies and gentlemen of the jury, I am but a simple caveman, discovered by your scientists and thawed from a block of ice. I don’t understand your modern world. It frightens me.”

Leveraged ETFs' Role in a Portfolio

The etf.com site has an entire section devoted to leveraged ETFs. And there’s nothing to be frightened of. That is, unless the person making the decisions on how to deploy these modern vehicles doesn’t understand how to properly use them.  

While there is no one “correct” way to do so, this month’s market panic was a very timely reminder of how leveraged ETFs can play a useful role. When investors accept them for what they are, and apply basic portfolio risk management techniques, they can potentially lower portfolio risk, not raise it, as many assume. They also may be useful as surrogates for options exposure.

It's All About Position Sizing

Those familiar with how to use options can consider investing a small amount of their portfolios in call options on an index or index-based ETF to try to increase the “beta” or sensitivity to market movement, aiming for a higher portfolio return.

Importantly, by using options, the investor’s loss on those options contracts is limited to the amount invested. So, a little potential pain for a chunk of potential gain.  

But when market volatility as judged by the VIX index spikes like it did recently—shooting five-fold to 65 before settling back in the 20s—options get very expensive.  

That’s when ETFs designed to multiply the movement of the underlying investment by two or even three times can potentially help. That is, if they are used properly.

Use Leveraged ETFs Responsibly

An investor who sought to do what many did last week and add some spice to their portfolio might have bought the Direxion Daily Semiconductor Bull 3X ETF (SOXL). Adding a 2% portfolio position would act like a 6% position in a traditional semiconductor ETF (i.e. with no leverage).  

That would increase the appreciation potential of that otherwise conservative 20% S&P 500 ETF Trust (SPY) allocation but would only put 2% of the portfolio at risk.

Now, 2% is $20,000 on a $1 million portfolio, so that’s not to be taken lightly. But whereas options have limited life spans, 3X ETFs don’t, other than the inherent backsliding effect on their value if they go the wrong way for too long.  

That’s why they are considered “daily” investment vehicles, though many investors hold them for weeks or longer. For instance, a position in SOXL bought at last October’s lows would have increased in value by 400% by July of this year. And, it has given back more than half of that peak value in just five weeks.  

If that sounds a lot like the type of movement one normally gets from options contracts, that’s the point. At times of higher volatility, options get very difficult to use. But leveraged ETFs can be considered as surrogates. 

What Could Possibly Go Wrong?

Even in a “worst case scenario” in which the investor fell asleep and later realized that the entire 2% investment in SOXL had fallen to near zero, the impact on the total portfolio return is at most 2%. As recently as the year 2022, the Invesco QQQ Trust ETF (QQQ) fell by 33%. So having just 6% of a portfolio in QQQ that year would have produced the same 2% overall negative impact on the portfolio’s returns.  

This emphasis on the downside risks of leveraged ETFs is understandable. But it has reached the point where, as I understand it, some advisor compliance departments don’t allow them. This is the case even though some of today’s largest ETFs, including SPY and QQQ, have suffered drops of 50%-80% or more during their histories.  

Risk is not in what you own. It is in how much of it you own. This is something for advisors and self-directed investors to consider when approaching modern tools such as leveraged ETFs. There’s no need to be frightened, like a caveman lawyer. Not if one studies the subject thoroughly.